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April 26th, 2011 (Modified on April 27th, 2011)

Here’s how borrowers could lose with new mortgage rules

by Peter Miller


iStock_Mortgage ApplicationOne of the strangest new requirements coming out of Washington is that borrowers must actually have the ability to repay their mortgages.

At first this sounds entirely ridiculous because mortgage lenders would seem to have an obvious interest in getting repaid. Unfortunately, given no-doc loan applications and other short-cuts that lead to the mortgage meltdown, the sense in Washington is that baseline mortgage requirements must be spelled out in detail–otherwise lenders will bend or evade the rules.

The Federal Reserve has now come out with four proposed standards that it says lenders can use to meet the new “ability-to-repay” requirements needed to originate a qualified residential mortgage or QRM. Unfortunately, a careful look at the standards suggests that huge loopholes and escape clauses still remain.

Here’s what the Fed proposes:

First, a creditor can meet the general ability-to-repay standard by considering and verifying specified underwriting factors, such as the consumer’s income or assets.

This proposal should fly through the system because it effectively ends no-doc loan applications–a central source of mortgage abuse. For borrowers, it means you’ll have to show evidence of income and employment (tax returns, W-2s, etc.):

Second, a creditor can make a “qualified mortgage,” which provides the creditor with special protection from liability provided the loan does not have certain features, such as negative amortization; the fees are within specified limits; and the creditor underwrites the mortgage payment using the maximum interest rate in the first five years.

An end to negative amortization would stop any re-introduction of option ARMs. However, that’s not enough. Patrick J. Lawler, the chief economist with the Federal Housing Finance Agency, said in congressional testimony that the definition of a QRM must include such benchmarks as loan terms which cannot exceed 30 years, and a “restriction” on interest-only, negative-amortization, balloon loans, and prepayment penalties. Also, he said, points and fees cannot exceed three percent of the loan amount, and there are payment caps on adjustable rate mortgages to reduce potential payment shock.

The question is, of course, just how “restrictive” will the restrictions be under the final rules?

Third, a creditor operating predominantly in rural or underserved areas can make a balloon-payment qualified mortgage. This option is meant to preserve access to credit for consumers located in rural or underserved areas where banks originate balloon loans to hedge against interest rate risk for loans held in portfolio.

“Underserved areas”? You mean inner cities? This is an obvious gift to lenders. As an example, lenders would be allowed to offer five-year “term” loans with payments based on a 30-year payment schedule. At the end of five years, the financing would have to be renewed or the borrower could face foreclosure. If this sounds familiar, it’s because this was the very type of financing commonly in use before the Great Depression and the establishment of the FHA with its self-amortizing mortgages.

To understand how term-financing works, imagine that you borrowed $200,000 at 5 percent interest. The payment for principal and interest would be $1,074 per month.

Now imagine that five years from now you lose your job or that local real estate prices decline. You no longer qualify for financing or have sufficient equity to refinance the property. The balance of the mortgage, the balloon payment after five years would be $183,658.

Where would you get the money?

Or, alternatively, imagine that in five years you have a job and the property has held its worth. What would be the closing costs of a new mortgage? What if the lender simply did not want to refinance the property?

Finally, a creditor can refinance a “non-standard mortgage” with risky features into a more stable “standard mortgage” with a lower monthly payment. This option is meant to preserve access to streamlined refinancings.

A lower monthly payment may not always be practical. For instance, some toxic loans have a monthly cost which is actually less than the interest expense. This is possible because such loans allow for negative amortization so the unpaid interest is added to the loan balance. A better approach to all of this would be to define a “non-standard mortgage” as inherently unstable and encourage conversion into a conventional, VA or FHA loan.

In the end, the Federal Reserve standards are exactly what you would expect them to be: standards that go as far as possible to assure the best interests of the lending community the Fed is supposed to regulate.

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3 Responses to “Here’s how borrowers could lose with new mortgage rules”

  1. Rob Says: May 1st, 2011 at 7:00 pm

    You all realize, of course, that except for interest only arms, every single type of loan mentioned above that the consumer is being “protected” from is virtually non-existent at this point? In fact, they have been for quite some time now. What’s next from the Fed, a rule requiring an appraisal on a house to do a mortgage? Talk about the horse being out of the barn already!

  2. Rob Says: May 3rd, 2011 at 6:04 am

    It’s been virtually impossible to get a no-doc loan since August 2010 or to finance a option ARM. This hasn’t happened because of lender restraint, it’s happened because under Dodd-Frank all qualified residential mortgage applications must verify income and employment.

  3. Rebecca Hall Says: May 31st, 2011 at 4:44 am

    Thanks for sharing such a useful information. I am definitely going to use it next time.

    Rebecca Hall

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